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Entrepreneurial Finance
Samuele Murtinu
Catholic University of Milan – Institute of Economic
Policy
[email protected]
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Introduction
• New Technology-Based Firms (NTBFs) are defined as small
businesses whose products or services largely depend on the
application of scientific and technological knowledge (Allen, 1992)
• Positive impact on static and dynamic efficiency, and economic
growth
Characteristics
• Rich endowments of intangible assets
• Lack of ‘‘hard’’ assets and collateral
• Short track record
• Founders with science/technology backgrounds but limited financial
and marketing expertise
2015 – Samuele Murtinu
Innovation and finance
Schumpeterian competition (Schumpeter Mark I technological
regime)
• Entrepreneurial firms play a fundamental role in innovative
activities, as they generate novelties which disrupt the quasi-rents
• Creative destruction process (Nelson and Winter 1982; Kamien and
Schwartz 1982; Breschi et al. 2000)
Role of finance
• Rate and direction of technical change are affected by the criteria
through which financial markets allocate resources (Dosi 1990; Aoki
and Dosi 1992).
• Banks and financial markets play the essential role of ‘‘bridges’’ or
‘‘facilitators’’ of the innovative efforts carried out by entrepreneurs
(Schumpeter 1911)
2015 – Samuele Murtinu
Financing gap
FINANCING PROBLEMS
• Informational opacity of new firms involved in R&D (patents vs.
secrets)
• Highly uncertain returns and costly monitoring
• Technology-intensive nature of NTBFs’ activity: complexity
• Lack of a consolidated track record
• High % of firm-specific and/or intangible assets  low collateral
HIGH DEFAULT
PROBABILITY
• Asymmetric information - moral hazard and adverse selection
(Akerlof 1970) – and transaction costs (M&M hp are violated)
• Difficult access to financial markets: wedge between the cost of
internal and external funds
• Financial constraints
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Financial constraints:
definition
A firm’s investment is constrained by the availability of finance if and only
if
• There are investment opportunities (Tobin’s Q)
• Such investment opportunities are more profitable (or strategically
profitable) than alternative uses of capital
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Financial constraints:
definition
Wedge between internal and external cost of capital
• Information asymmetry (Akerlof, 1970)
• Asset intangibility
• Track record
• Investment specificity
• Cash flow stability
• Market demand
• Capital structure (Modigliani and Miller, 1958)
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Varieties of capitalism
Financial systems are classified within different varieties of capitalism:
• Germany, Japan and Scandinavian countries are bank-based systems
• UK and US are market-based systems
Countries also differ in terms of
• Tax and bankruptcy codes
• Ownership dispersion
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The role of banks
R&D funding-gap: internal cash flow as primary source to invest in
R&D projects (Hall & Lerner, 2009):
• Asymmetric information
• Lack of collateral assets/low ratio of tangibility
• Credit risk assessed through financial ratios and historical data
(tendency to invest in government bonds)
• Banks are not able to separate good projects from 'lemons' in
industries characterized by skewed returns
• High pro-ciclicality of R&D investments
• Discontinuity of R&D investments
• Banks invest in traditional industries: food, beverage, healthcare,
utilities
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The role of banks
• IF: internal finance (=CF)
• `lenders are only concerned with the bottom part of the tail of the
distribution of returns' (Stiglitz, 1985: p. 146):
– Credit rationing (Stiglitz and Weiss, 1981)
– Higher interest rate
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(Indirect) Costs of bankruptcy
Loss of customers
• Hw/sw  no support/upgrade
• Airline tickets  failure to honor frequent flier schemes
• Manufacturers of durable goods  warranties/replacement parts
Loss of suppliers
• Inventory
Loss of employees
• Lack of job security/Hiring-away
• Difficulty to hire new employees
• Important for firms whose value largely depends on human resources
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Indirect costs of bankruptcy
Loss of receivables
• Difficulty in collecting owed money
Fire sales of assets
• Firms forced to sell assets quickly to raise cash (i.e., acceptance of a
lower price; airlines: -15/40% in the selling price of aircrafts)
• Subsidiaries
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Agency costs
NTBFs are usually owner-managed
In any case, managers are hired and retained with the approval of the
owners
LEVERAGE  conflict of interest: when the risk of financial distress is high,
managers may choose investment decisions that benefit shareholders
but harm creditors:
• Over-investment
Agency costs are smaller for short-term debt (less time for moral hazards).
The firm is obligated to repay its debt more frequently
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Agency costs
OVERINVESTMENT
V = 400
D = 390
E = 10
Timing: close to debt obligations
Investment A  PV = 10
Investment B  PV = 90%(-30)+10%(200) = -7
Baseline situation:
V = 400
Payoff (debt holders) = 390
Payoff (shareholders) = 10
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Agency costs
Investment A:
V = 400 + 10 = 410
Payoff (debt holders) = 390
Payoff (shareholders) = 20
Investment B:
V = 400 -30 = 370 (prob. 90%) OR V = 400 + 200 = 600 (prob. 10%)
Expected V = 370*0.9 + 600*0.1 = 393
Payoff (debt holders) = 370 (prob. 90%) OR 390 (prob. 10%)
Expected payoff (debt holders) = 370*0.9 + 390*0.1 = 372
Payoff (shareholders) = 0 (prob. 90%) OR 210 (prob. 10%)
Expected payoff (shareholders) = 210*0.1 = 21
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Agency costs
Investment A is the best one for the firm because:
- It allows to pay debt-holders
- It increases shareholders’ wealth (10  20)
Investment B INSTEAD:
- With a very high likelihood (90%) leads the firm to bankruptcy
- With a very high likelihood (90%) the firm does not pay the debt
HOWEVER…
Shareholders will choose the investment B (their payoff is higher)
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The role of business environment
Obstacles to growth are a function of
• Development of financial and credit markets
• Efficiency of legal systems
• Shareholder and creditor rights
• Regulatory burdens
• Corporate taxes
• Bankruptcy processes
• Perception of corruption
• IPR protection
• Provision of infrastructures
• Crime
• Political stability
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The role of firm-specific characteristics
Obstacles to growth are a function of
• Size: power of banks decreases with borrower size (Petersen &
Rajan, 1995)
• Age
• Ownership
• Networks
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Pecking-order theory
Entrepreneurs prefer (in order):
• Internal finance
• Debt
• Equity (does not require collateral, and does not increase the likelihood
of financial distress)
Sometimes, firms are not able to grasp business opportunities because of a
lack of external finance
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Pecking-order theory
Reasons:
• max(π) is ONE of the GOALS
• Financial markets are not EFFICIENT (Modigliani and Miller, 1958), as
assumed by traditional neoclassical models
- No full information (entrepreneur vs. investor)
- Information are costly
 Adverse selection (Akerlof, 1970)  second-hand cars
VG = value of a “good quality” car
VB = value of a “bad quality” car
Customers cannot evaluate which are the good cars
Dealers are not able to signal the quality of their cars
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Pecking-order theory
If we assume that in the market:
• 50% good cars
• 50% bad cars
Customers’ willigness to pay = (VG + VB)/2
Result: dealers “put on the market” BAD CARS ONLY!
In the long run: customers expect that there are only bad cars in the
market and will pay VB
Conclusion:
GOOD FIRMS SELF-SELECT OUT from the financial market  MARKET
FAILURE!
2015 – Samuele Murtinu
Pecking-order theory
Why DEBT before EQUITY?
First possible reason: DILUTION
Example:
n = 500 million
p = $16
Equity market value = n*p = $8 billion
Necessity to invest $1 billion through new equity issuance
nnew = $1 billion/p = $1 billion / $16 = 62.5 million
p before = $16
p after = $9 billion/562.5 million = $16
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Pecking-order theory
Second possible reason: firm is underpriced
The use of DEBT varies greatly among industries
Firms in high-growth industries (e.g., biotech) use little debt, while airlines,
automakers, utilities and financial firms have high leverage ratios
Firms in high-growth industries do not have any taxable income. Their
value comes from their potential to produce high profits in the future
(e.g., drugs with tremendous potential).
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Pecking-order theory
When the marginal cost of debt financing becomes sufficiently high, new
equity financing becomes the least-cost marginal source of finance
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The role of private venture capital (VC)
• Positive impact of VC on NTBFs’ performance: innovation, growth, TFP,
and likelihood of going public
• Context-specific screening
• Monitoring and value-added (financial, marketing, human resources,
and operations management)
HOWEVER
• Focus on a limited set of industries
• Backing of a very small fraction of ‘potentially investable’ NTBFs:
– Kaplan & Lerner (2014): 1,200 firms out of 600,000 firms (with employees)
in the period 2009-2013 (0.2%)
FINANCING GAP
MARKET FAILURE
2015 – Samuele Murtinu
The role of private venture capital (VC)
The GP is
typically a limited
liability company,
participated only
by the fund
promoters, and is
an unlimited
shareholder of
the fund. For
sake of
credibility, it also
provides a
(small) fraction
of the VC fund
Investors are limited shareholders of the fund,
with priority in case of liquidation
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Statistics on VC fundraising
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Screening
What VCs consider:
• Quality of the business plan and coherence with investment policies
• Founders’ human capital
• Expected growth of the business
• Innovation (and means to protect it)
• Synergies with other portfolio investments
• Way-out perspectives (4-7 years)
RATE OF
RETURN
• Market conditions and timing are important
• Specialization vs. diversification
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The deal structuring
The main issues to be discussed between the VC and the entrepreneur are
related to:
• Price to be paid for the shares, in excess of the par value; if the price is
‘low’ the entrepreneur is selling his project at a discount, while if the
price is ‘high’ the VC profitability will be lower (target IRR)
• Stage financing, according to the achievement of the business plan
milestones
• Composition of the board
• Options held by the VC (e.g. ‘tag-along’ or ‘drag-along’ clauses, supermajority, take-over clauses, pre-emption and veto rights)
• Way-out perspectives
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VC investments as % of GDP
(country of portfolio companies)
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VC investments as % of GDP
(country of VC funds)
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Europe vs. US
VC investments
• USA (19.1 billion € in
2011; 0.13% of GDP)
• EU (3.9 billion € in 2011;
0.03% of GDP)
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Exit
The exit may occur in one of the following ways:
• IPO: the company is taken public with an Initial Public Offering, and
access the Stock Exchange; the VC stake is part of the IPO
• Trade sale: the VC stake is sold with a private offer, to a bidding
company, or to another fund, or the entrepreneur buys back the shares
• Write-off: in case of failure and poor performance, the venture is left to
its own destiny and the investment is written-off
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